LM03 Guidance for Standards I-VII

Part 8

Standard V: Investment Analysis, Recommendations, and Actions

Standard V (A) Diligence and Reasonable Basis

Members and Candidates must:

1. Exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions.
2. Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action.

Interpretation:

The level of diligence and thoroughness of research depends on the investment philosophy the member/firm is following and the role of the member in the investment decision-making process.

Guidance:

• Define diligence and reasonable basis.
• When using secondary or third-party research (research conducted by someone outside the member’s firm) make reasonable efforts to ensure third-party research is sound.
• Ensure the firm has a policy about periodic review of approved third-party research providers. If not, you must encourage the firm to adopt a formal review practice.
• You may rely on the judgment of others (senior managers) in your firm if you believe the due diligence done by them was adequate.
• When using quantitatively oriented research, ensure the soundness of models. You are not expected to become an expert in every technical aspect of the models, but you must understand the data, parameters, assumptions, and limitations of these models. Test the output of these models under various scenarios before distributing the product. Ensure that the model includes a broad range of scenarios – even high-risk and potentially negative outcomes that are not commonly encountered.
• Developing quantitatively oriented techniques: If you are involved in developing new models/algorithms, then you must exercise higher diligence in reviewing new products than individuals who would use these models. Include data for both positive and negative economic cycles. Test models using adverse volatility and performance expectations. Test the model for a wide range of input expectations.
• Selecting external advisers and sub-advisers: If you are using external advisers to manage a specific mandate, then you must diligently review them just as you would an individual fund/security. Review if the published return information is accurate. Understand the adviser’s compliance procedures, investment process, and if he/she adheres to the stated strategy.
• Group research and decision making: Often, members and candidates are part of a group that collectively produces an investment analysis or research. The group arrives at a consensus and gives a recommendation. The names of the members are included in the report. If you do not agree to the final recommendation, but believe that consensus opinion has a reasonable and adequate basis, and is independent and objective, then you need not dissociate yourself or ask that your name be removed from the report.

Recommended Procedures for Compliance:

• Establish a policy that research reports must have a reasonable and adequate basis. Either an individual or a review committee consisting of a group of employees must be appointed to review the report before it is circulated to the outside world.
• Develop written guidance for analysts, supervisory analysts, and review committee that outline due diligence procedures if a recommendation has a reasonable and adequate basis.
• Develop criteria for assessing the quality of research.
• Develop written guidance for testing of all computer-based models.
• Develop measurable criteria for assessing outside providers. This relates to the guidelines for using external/third party research (we saw this in the previous section).

Standard V (B) Communication with Clients and Prospective Clients

Members and Candidates must:

1. Disclose to clients and prospective clients the basic format and general principles of the investment processes they use to analyze investments, select securities, and construct portfolios, and must promptly disclose any changes that might materially affect those processes.
2. Disclose to clients and prospective clients significant limitations and risks associated with the investment process.
3. Use reasonable judgment in identifying which factors are important to their investment analyses, recommendations, or actions, and include those factors in communication with clients and prospective clients.
4. Distinguish between fact and opinion in the presentation of investment analyses and recommendations.

Interpretation:

This standard emphasizes the need for communicating clearly and frequently with clients. It is important to communicate to clients what factors they considered while making the recommendation. If there is a change in the risk characteristics of a security or asset, then this must also be communicated.

Guidance:

• Informing clients of the investment process: Describe your/firm’s investment decision-making process to the client. This must include the pros and cons, risks and limitations of the process.
  • Just communicating the final recommendation (for instance, buy/sell a security) to the client is not sufficient. You must explain in simple language the investment process.
  • If there is any change in the process, inform the client.
  • Communicate to the client if any external advisers are being used for their expertise to manage a specific strategy.
• Different forms of communication: Communication is not restricted to traditional written report. It could be in-person meetings, e-mail, telephone conversation, etc.
  • Care should be taken when communicating through social media.
  • If the recommendation is concise (stock-list), then you must notify clients that additional information will soon be made available.
• Identifying risk and limitations: Disclose to clients the risks and limitations of the investment process/product.
• Report presentation: In the report include those elements that were important for analysis and conclusion.
• Distinction between facts and opinions in reports: Assume you are recommending a sugar stock because you believe that the government will raise the export quota limit. But, this has not been done yet; so, it is just your opinion. You must distinguish between facts and opinion by stating this is an opinion. However, for instance, if you were presenting the performance of the past three quarters, then this would be a fact.

Recommended Procedures for Compliance:

The information included/excluded in research reports varies given the diverse nature of clients and investment assets. There is no specific checklist for what must be included. But, firms must have a rigorous methodology to review research meant for dissemination to clients.

Standard V (C) Record Retention

Members and Candidates must develop and maintain appropriate records to support their investment analyses, recommendations, actions, and other investment-related communications with clients and prospective clients.

Interpretation:

Members and candidates must retain records that support their research, analysis, and conclusion. What records to maintain depends on the member involved in the decision-making process. Records can be maintained either in hard copy or electronic format.

Guidance:

• New media records: It is the member’s/candidate’s responsibility to maintain a record of information posted/discussed in social media even if the firm does not have a record retention policy yet. Examples include twitter/blog posts, Facebook updates, etc.
• Records created as part of any professional activity are the property of the firm; if a member decides to leave the firm, he/she cannot take the records or supporting documents without the consent of the previous employer.
• Members cannot reuse historical research reports if the supporting documentation is not available.
• Every country/jurisdiction where you operate may have certain rules for how much data to retain. For instance, a country’s regulator may call for retaining data for the past five years. Similarly, firms may also have policies for retaining research/communication records. CFA Institute recommends retaining records for at least seven

Recommended Procedures for Compliance:

• The responsibility to maintain records that support investment action generally falls with the firm rather than individuals.
• You should archive research notes and other documents that support investment-related communications.
• If the firm has policies and procedures to facilitate record retention, then you must follow them. If not, you must encourage your firm to adopt policies for preserving records.

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